Who Credits the Creditors?

If you are like most people with credit cards, you have probably never stopped to ask yourself “where did this money that I have borrowed come from?” Most people would simply assume that the money comes from their issuing bank, and they would largely be correct in this assumption. However, as is often the case in the world of banking and high finance, matters are far more complicated than they may initially appear.

It is true that in some sense when you make a charge on your credit card the money that goes to the merchant, or party to which you are making a payment, comes from the issuing bank or credit lender.

Lets take for example Capitol One — they are one of the largest credit card, home, and auto loan lenders in the United States. So much so, in fact, that they are the fourth largest customer of the US Postal service. I suppose  mailing out all those monthly credit card statements makes a few mail men very happy!

When you make a purchase with your Capital One credit card, Capital One makes that payment for you out of its massive pool of operating funds. Each month all of those payments are tallied up and mailed to you as your monthly credit card statements and you can choose to either pay it off or leave a balance on the card and be charged your monthly interest rate. If you decide to go with the latter and allow your balance to revolve from one month to the next, you can consider that balance to be a loan that Capital One has made to you.

Lenders like Capitol One have lots of loans just like that on their books, and they are literally the bread and butter of the credit card industry, because it is from these outstanding loans to individuals that Lenders make money by charging interest. But if they were to pay for your purchases (and everyone else’s) directly, lenders would have to have enough cash on hand to cover not only the outstanding loans, but also to accommodate new expenditures from its customers. According to the US Census Bureau as of 2010 nation wide those outstanding loans total nearly $929 Billion, with roughly $2.1 Billion in new annual expenditures.

That means the credit card lenders would need to have close to a trillion dollars (in cash if payments were made all at once, or in assets if it were over time) on hand to absorb the outlay of loans. This is astronomical considering that the 5 biggest credit lenders in the US (BAC, JPM, Citi, COF, WFC, which account for a disproportional part of the industry) had total collective revenues of $388 billion. How do they achieve this titanic feat of financial leveraging? A little thing called securitization.

The concept of securitization is simple enough: the value of lots of little assets are gathered together into huge lots or pools and sold to investors. The idea is that the seller gets to pass on the burden of all those assets to the investor, while the investor gets to earn a yield in exchange for agreeing to bare the burden of all those assets. In the case of debt, the burden of the assets is the risk that at any time any number of them may go into default, while the yield the investor earns by exposing his money to those risks is drawn from the monthly payments or interest rates charged to those who are in debt. It functions similarly to a bond in that the institutions are agreeing to finance someone else’s debt in exchange for a series of payments with a yield.

If all of this sounds incredibly familiar to you, that’s because unless you have been living under a well insulated and comfortable rock since 2007, you will have felt the effects of the world wide financial crisis and the recession in its wake, all of it triggered by the collapse of mortgage-backed securities. You may recall during recent times hearing the acronyms CDO or ABS tossed around like some sort of toxic hot potato.

Collateralized Debt Obligations (CDO‘s) and Asset Backed Securities (ABS) are considered a type of securitization and are the functional reason for the recent economic down turn we are facing. In this case, the outstanding debt from home loans all across America were packaged up and sold on to large institutional investors. These investors agreed to take on the burden of the outstanding debt of all those mortgages in return for the payments made each month by the home owners. This allowed mortgage lenders such as Fannie Mae and Freddie Mac to pass on the risks of default and continue making new home loans without having massive amounts of cash on hand.

When a small hiccup in the economy caused a large swath of home owners to become unable to make their mortgage payments and to enter default, disaster ensued. Since the risk of this event had been so spread around and passed on so widely, so too were the effects of it. Some of the largest financial institutions in the world were dealt a massive blow. The effects of this blow and the repercussions it caused can be viewed by examining the state of the American economy at present.

This lovely little trick of securtization is the same trick credit card companies use to tackle the massive amounts of outstanding credit card loans as well as cover incoming expenditures. It would be next to impossible for card issuers to completely cover all of the outstanding debt as well as account for their exposure to risk from those debts without securitizing some of it and passing it on.

The financial industry calls these “Credit Card Receivables” because the asset backing them is the payments received each month and the promise of all future payments.  They are therefore a form of Asset Backed Securities. The exact amounts of how much credit card debt is securitized and sold off is difficult to measure and is in constant flux. Credit card companies are only allowed to sell off between 20%-50% of their Receivables as securities. That means that at any given moment between 20% and 50% of the roughly $900 billion dollars in credit card debt ($150B-$450B) is in ABS and spread around the market. According to Fitch IBCA in 1998 the top 10 issuers of Credit Card Receivable-ABS (the most recent year for which this information is freely available) issued roughly $160 in Credit Card securities.

This isn’t supposed to be all doom and gloom however. We’re not trying to scare you in to thinking that the next looming fiscal disaster America faces is a credit card shaped security right around the corner. As was stated before the total amount of outstanding debt in the credit card industry is roughly $900 billion, this is less than one tenth of the total estimated $10 trillion of the US mortgage market. Furthermore, though we would like to think given our current national economic situation that securitization is a bad thing, it actually serves an invaluable financial purpose.

There are numerous benefits for consumers by allowing Credit Card companies to engage in this type of activity. These include but are not limited to : lower interest rates paid by consumers, greater penetration of credit card services to consumers, larger amounts of available credit, and credit card rewards — all available because card issuers are able to mitigate their exposure to risk through securitization.

So if you ever happen to wonder who actually paid for that brand new toaster on your counter, the answer is:  the cost of that toaster and the interest you have agreed to pay on it was fronted by your card issuer. It was then packaged into a large aggregate pool of credit card receivables and securitized, after which the issuer then passed that security on to large institutional investors who agreed to back your toaster’s purchase in exchange for the yield on your future payments.

It’s so simple!

Image 1 by natloans
Image 2 by aresauburn
Image 3 by DragonFlyEye
Image 4 by Photo4jenifer

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